March 01, 2010

With the looming threat of Congress passing legislation that would curtail the application of valuation discounts for minority interests in family-controlled entities, estate planners are exploring other techniques to accomplish their objectives. One method that is getting more attention is the use of intra-family loans.

From a valuation perspective, estate planners are also taking a close look at estate plans and family transactions executed prior to the credit crisis and economic malaise of 2008 and 2009. The market downturn has disrupted many estate plans as recently transferred assets have declined in value or have not met investment expectations. In some succession planning situations, the inability to obtain independent bank financing may have left no alternative but to utilize a related-party promissory note. Now, shifting risk tolerances of clients may warrant a change to the structure of a related-party debt agreement, such as an individual no longer being comfortable with a personal guarantee.

While the use of intra-family loans can provide a low risk method of achieving estate planning objectives in a volatile economy, even the best intentioned plan can lead to unexpected surprises in the form of taxable income or gift tax.

Intra-family loans, forgone interest, debt forgiveness, or a rescinded personal guarantee can trigger a gift tax, as it may be considered income to the recipient. From an IRS perspective, personal loan guarantees may be considered a transfer of economic value as a loan with a personal guarantee should allow the borrower to receive a more favorable interest rate.

The consequences of debt forgiveness, or other events, such as rescinding or buying out a personal guarantee, may warrant a valuation of that specific attribute to determine its Fair Market Value. The following section provides an overview of the valuation of a promissory note and the attributes that impact value.

Note Valuation

The method utilized to value a promissory note is dependent on the financial condition of the debtor. If there is a reasonable expectation that the debtor will be able to meet the financial obligations of the note, then the value of the note may be determined based on the present value of the future note payments discounted at a market-derived rate of return. If the debtor is unable, or if there is uncertainty if the debtor will be able, to meet the financial obligations of the note, then the value of the note is equal to the expected proceeds to be received through a liquidation or bankruptcy of the debtor.

In valuing a note, the rate of return (or market yield) applicable to the note is estimated based on the risk inherent in the investment. In other words, an investor would accept a rate of return no lower than that available from other investments with equivalent risk, and would value the investment accordingly.

Generally, the longer the term of the note, the higher the rate of return an investor will require due to the risk of changes in prevailing interest rates during the term of the note. In addition, assessing the debtor’s underlying creditworthiness has an impact on the market yield. This can be assessed by analyzing cash flow and coverage ratios. Higher coverage and cash flow ratios reduce the risk that the debtor will be unable to make its regular debt service payments, thus indicating a lower yield is applicable.

If the collateral of the installment note is a private operating company, it may be possible to identify a comparative group, or class, of publicly traded debt instruments issued by companies with similar characteristics of the private company in determining an appropriate market yield. In general, the greater the collateral or security position, the lower the rate of return required by an investor. The IRS has provided guidance of the relevant factors to consider in determining the Fair Market Value of a note through Technical Advice Memorandum (“TAM”) 8229001, which include the following:

  • Presence of or lack of protective covenants in the note;
  • Nature of the default provisions and default risk;
  • Market for purchases and resale of the note;
  • Financial strength of the issuer;
  • Value of the security (i.e., the collateral);
  • Interest rate and term of the note;
  • Comparable market yields;
  • Payment history; and
  • Size of the note.

Components of a Market Rate of Return

In general, a required rate of return is comprised of three components: 1) a time value of money component; 2) a risk premium component; and 3) a marketability or liquidity component. The first component, time value of money, represents the rate of return that one could obtain in an investment with little or no risk of losing the interest or principal on the note. The U.S. government bond is often used as a benchmark for a risk-free investment and is considered a proxy for the time value of money.

The second component, risk premium, is comprised of many specific types of risks. For example, a portion of the risk premium represents compensation for interest-rate risk. Maturity is a major determinant of interest-rate risk. Interest-rate risk is a significant risk faced by an investor of debt instruments in the public marketplace. Additionally, investors face the variability in returns from their reinvestments due to changes in market rates (i.e., reinvestment risk) or potentially the loss of a portion or their entire investment if the borrower declares bankruptcy (i.e., default risk). Risk premiums can be directly observed by analyzing market yields of publicly traded corporate and high-yield debt in excess of the risk-free rate.

The third component represents the marketability of the investment and reflects how quickly one can obtain liquidity from an investment. Factors that affect marketability include: restrictions on transfer of the security, the pool of possible investors, the size of the security, and the amount of available information related to the issuer. The more obstacles to finding a potential buyer, the more illiquid the investment and, accordingly, the higher the rate of return one would require.

Market Yield Analysis

As illustrated in the following table, the market yield increases depending on the time horizon and the level of perceived risk of the investment. The first four securities are government-issued securities and, therefore, free of default risk. The difference in yield between the 20-year Treasury bond and the 1-year Treasury bill is due to the duration of the security, which increases interest rate and reinvestment risk. The next two yields are “investment grade” corporate bonds based on creditworthiness as determined by a rating agency. The yield spectrum continues with securities that fall below investment grade, and carry substantial default risk. Also typically considered are yields on mortgage debt and unsecured personal loans available through financial institutions. The increased risk associated with the lack of collateral causes a significantly higher yield to be demanded by the market.

Assessing the risk of a promissory note focuses on three areas, including an assessment of the creditworthiness of the borrower from a financial standpoint; an assessment of the risk from a governance standpoint; and an assessment of the marketability attributes associated with the debt instrument. In other words, an analyst seeks the answers to the following questions:

  • Will the borrower have the cash to pay the debt obligation?
  • Can the debt holder prevent the borrower from acting in a high-risk manner?
  • How difficult will it be to gain liquidity?

The table above presents an example of a basic note valuation, whereby the expected cash flows are discounted to present value based on the market interest rate, and summed to determine the Fair Market Value of the note.

While most of the attributes of a note valuation may seem intuitive, certain attributes of intra-family loans can present complex valuation issues. Let’s say the individual’s financial position, or risk tolerance, has changed in light of recent economic conditions such that they wish to rescind, forgive, or be bought out of a personal guarantee on an intra-family loan. This event may warrant a determination of the Fair Market Value of the personal guarantee associated with the promissory note.

Valuation of a Personal Guarantee

Empirical studies and market data are fairly limited as it relates to the specific valuation of a personal guarantee. The appropriate methodology to apply will ultimately depend on the facts and circumstances of each case. The following describes two ways in which the valuation assignment may be approached.

Income Approach – “With Scenario” versus “Without Scenario”

To the extent an income approach can be applied in valuing the subject note, one approach to ascribing value to a personal guarantee would be to determine the reduction in the market-derived interest rate made possible by the personal guarantee. That is, a comparison of the value derived from each scenario utilizing different market interest rates – one scenario assuming the personal guarantee is present and the alternative scenario incorporating an interest rate assuming that no personal
guarantee exists.

This approach would entail a determination of the applicable market interest rate absent the personal guarantee. As such, the steps would include an assessment of:

  • The probability of default over the term of the loan;
  • The likelihood of utilizing the personal guarantee; and
  • Quantification of the incremental yield on the applicable market interest rate.

Put Option Theory

While a personal guarantee on a debt instrument and a put option on a stock may seem completely unrelated, option pricing theory may provide some insight into developing a framework. This method employs the theories and formulas used to value stock options in the valuation of other financial claims. Unlike common stock, a personal guarantee on debt has a return spectrum that is asymmetric in nature. In other words, a guarantor has limited upside if the borrower’s creditworthiness or collateral position improves, but nearly limitless downside if the borrower becomes insolvent and the collateral position declines in value. The asymmetric nature of a personal guarantee on debt is similar to the characteristics of stock options and, thus, makes it possible to consider an option-pricing model to estimate the value.

When an investor sells a put option, the seller receives a payment for writing the option in exchange for agreeing to pay the buyer of the option an amount equal to the exercise price less the asset price, upon exercise by the buyer. When the seller of the put option enters this agreement, the investor is accepting a contingent liability. The contingent liability will become an actual liability only if the asset price of the security declines below the strike price. Because the seller is paid a premium for writing the option, the fee received is inherently the value of the contingent liability.

The most widely used option pricing model is the Black-Scholes Option Pricing Model (the “Black-Scholes Model”). The Black-Scholes Model is an arbitrage-pricing model that was developed using the premise that if two assets have identical payoffs, they must have identical prices to prevent arbitrage (i.e., riskless profit). The model calculates the price of a traditional put option by analyzing the volatility and opportunity cost of investing in the underlying asset. The Black-Scholes Model relies on five variables:

1| Asset price;
2| Exercise price;
3| Term;
4| Risk-free rate of return; and
5| The underlying asset’s price volatility (or level of risk).

Once a valuation analyst has made an assumption for each of the inputs into the Black-Scholes Model, these inputs can be used to calculate the value of the put option. However, it is important to understand the impact that each of the inputs will have on the value of the option. For example, the longer the term and the higher the volatility, the more likely it is that the option will ultimately be exercised, producing a higher value of the option. Alternatively, the higher the asset price relative to the strike price, the less likely the option will be exercised. This will result in a lower value of the option because the asset has more room to decline in value before the option will be in the money.

As presented above, in the case of valuing a personal guarantee on debt, some of the terms pertaining to traditional stock option inputs of the Black-Scholes Model are converted to terms pertaining to a personal guarantee. The theory, however, remains the same.

In establishing a framework to value debt and debt attributes, an assessment of the collateral position is required. That is, an investor would consider the value of the assets that are available to cover the claim of the guaranteed debt. For the purpose of this analysis, this total asset value is identified as enterprise value (“EV”), which is comprised of both the debt and equity components of the enterprise.

In this example, as presented in the following table, the exercise price of $50 equates to the value of the debt that is being guaranteed. In order for the personal guarantee to be invoked, the EV (i.e., total asset value) of $100 would have to decline below the value of the debt, and would result in the effective exercise price of the option. Further, the asset price, (i.e., the stock price in a traditional option model) equates to the EV in the personal guarantee valuation, and represents the total value that is available to satisfy the claim of the guaranteed debt. If the EV declines to $40 at maturity, or in the event of default, the guarantor is obligated to pay $10 to cover the deficiency and make the issuer whole. Given the existence of this potential downside protection, an issuer would accept a lower rate of return on debt with a personal guarantee relative to a debt instrument in which a personal guarantee is absent. The other inputs of the Black-Scholes Model remain virtually the same as a traditional stock option valuation.

An individual that guarantees a debt obligation is entering into a similar arrangement as that of a seller of a put option. If the value of the company that issued the debt declines to a level below the amount of the debt outstanding, the guarantor has the obligation to fund the shortfall. The personal guarantee is effectively a put option, with the debt value being the exercise price. For accepting this contingent liability, the guarantor needs to be compensated by the borrower, just as an investor that sells a put option on stock is compensated through the premium paid by the buyer. As such, in consideration of the other inputs in the model, including the volatility of the EV and the length of time that the personal guarantee is in effect, the calculated price of the option results in the estimated value of the personal guarantee.

Conclusion

While valuation issues involving family transactions and related party debt are common, in light of the current economic and legislative environment, issues involving intra-family loans are becoming more prevalent in estate planning. In addition, certain debt attributes can be quite unique, posing challenging valuation assignments. The valuation framework and methodology described in this article present both basic and sophisticated valuation concepts and other important attributes for estate planners to consider in structuring intra-family loans.